This quarter's special market
commentary begins with a quote from one of the
market's most successful hedge fund managers.
The quote implies that only hard decisions, or
those decisions that are not obvious, create excess
alpha. The topic of this quarter's piranha soup
is equities and the decisions in that space are
not obvious. The recovery period is behind us
and as we move into the cycle of monetary based
speculation, the decisions get harder.
Below I present a case for the great opportunities that lie
ahead in all equity hedge strategies, including equity market
neutral. For this analysis, the definition of "equities"
includes the strategies of equity hedge, statistical arbitrage,
sector funds, equity market neutral, and all other long short
strategies that are equity stock selection oriented. It does
not include equity non-hedge or short selling but some of
the analysis does apply. For the sake of simplicity, I will
use the same pattern of four factors I have used in prior
commentaries. First, I will revisit the last six months.
Here is a quote from my last quarterly commentary in April
(sorry for skipping July). "There is a mass exodus
from equity hedge primarily in the US and Europe. The percentage
of managers meeting investment targets is extremely low and
if emerging markets are removed, it is under 5%. The exodus
is so pervasive; it suggests a low point in the strategy."
Equity hedge has had a very strong reversal for the last
two quarters April to October. Industry results were positive
10.5% in the period. Here is the chart of rolling returns
for long short.
And here is the chart for equity market neutral.
The second chart of market neutral above shows the strategy
is still producing dismal returns. The first chart of equity
hedge does suggest a turning point in the strategy. But if
I dissect the returns of equity hedge managers, all that has
really happened is that hedge funds have been forced to lift
their shorts to stop the bleeding and are now net long beta.
There is really very little net alpha being produced for clients
across all managers in the pool. Clearly hedge funds are being
left in the dust by long side trades in just about anything.
This is about to change. My reasons for this prediction do
not include an expectation of a raging bull market nor extremely
strong earnings to justify current prices. My reasons all
point to a normalization of market dynamics in stocks. It
is a hard call now to step into equity hedge managers when
there is little alpha and it is especially hard to step into
equity market neutral. But this should be the core focus of
portfolios as we all transition out of debt strategies. Below
I present the four factors mentioned and then immediately
after I present the implications for how to cycle through
specific equity sub strategies in the coming two years.
Four factors that lead to strong alpha in equity strategies:
The four factors occur in a specific order and so I present
them in the proper order. They are: 1. A normal range of
volatility, 2. Stable economic indicators, 3. Geographic decoupling,
and 4. Individual market dispersion. Some of these concepts
are as hard to digest as piranha soup (which is very delicious)
so I will go over them in some detail for the benefit of all
- A normal range of volatility is a prerequisite for selecting
stocks because extremely high volatility comes from factors
external to companies. If we look at periods of extreme
volatility in stocks as now measured by the VIX, in all
cases the market is pricing high levels of economic risk.
Essentially volatility is a high payment for the fact that
the short seller of equity options has great uncertainty
as to how to price the stock in an unstable economic environment.
So by definition, the person selecting stocks does not know
how to price the stock either.
Stock selection is about companies and their unique fundamentals,
not terrorism. External shocks are by their nature unpredictable.
This is true even if the shock is from a company, like
the failure of Enron or a blow up in WorldCom. One is
tempted to point out that these extreme periods of volatility
create opportunities. It is true that periods of dislocation
rewrite the playbook for companies and cause miss pricing
of equities. It is also true that it takes about 12 months
for markets to settle down enough to give managers an
environment where they can pick stocks again. Right now
we are about 13 months from the peaks in volatility that
occurred in 2002. Markets are stable enough for stock
Periods of extremely high volatility are also periods
when equity managers tend to lower risk and carry large
quantities of cash. They recognize their own inability
to deal with the environment. Cash is poor alpha engine.
During the last 18 months, we have seen a trend toward
small balance sheets so whatever alpha is being produced
is being eaten up in fees.
For those that are more technically oriented, extremely
high volatility is normally accompanied by extremely high
correlation between equity market indices, extremely high
correlation between stocks and their respective indices,
high correlation across geographic boundaries, and even
unusually high correlation among currency and commodity
markets. While these are dealt with in points 2-4, it
is worth noting that they all reach their extreme points
while volatility is peaking. It is obvious that if all
stocks are correlated to the general market, and all markets
are correlated to each other, we are all just market timers
in the same trade.
Most stock pickers are poor market timers and it is worth
noting that the equity hedge funds doing well now are
those with top down market timing methods. This analysis
is a commentary about the shift from the top down methods
to bottom up methods. The chart below shows the relationship
between high volatility and poor returns in equity strategies.
Even if net beta is stripped out, the relationship holds.
Specifically the chart shows a rolling return in long
short against a rate of change in the Vix. A rate of change
in the VIX is used to show because it more accurately
predicts when the returns of the strategy are going to
turn. The point is that high vol is bad for equity strategies
and rapidly rising vol is really bad.
- Stable and trending economic indicators are also needed
in order to select stocks. This is separate from a decline
in volatility. Stock pickers need an economic environment
that they can predict. The most obvious reason is that economic
factors lead directly to the prices of companies. Across
international borders a revaluation of currency directly
affects the competitive value of a company. If currencies
are unusually unstable and/ or turning in trend, equity
hedge fund managers have a harder time.
In the case of many market neutral systems, economic
factor loads are the main source of price prediction models.
Obviously this primarily affects statistical arbitrage
but it also affects other valuation systems. A factor
load is a factor that explains of price behavior in stocks.
Beta is one example but all stocks are affected by factors
unique to their region, sector, and company. For example
oil drilling stocks are affected by the price of oil far
more than a company like EBay. When the factors themselves
become unstable, the models that predict the prices become
unstable. Instability comes in many forms including statistical
outliers. In recent times like 2002 there were so many
statistical outliers creating "new" factors,
models would need to be rewritten to keep up. An obvious
example is accounting fraud. This has contributed and
continues to contribute to instability in some of the
systems that have been reliable in the past.
One way to tell that equity funds are going to have a
difficult time is to see how currency predictive systems
are doing. If those systems are suffering, it is not yet
time to assume equity hedge alpha will be better. Once
those systems turn, alpha should follow. These systems
Economic indicators need to be somewhat stable within
an economy as well. We all know for example that this
US recovery cycle is unusual. Productivity is off the
chart. Employment is absent. Capacity utilization is weak.
Interest rates are at historic lows. Corporate earnings
leverage is at an all time high. Trade deficits are soaring.
There was no consumer recession. All of this adds up to
a complex picture. One might say that hedge funds are
in the business of doing a better job of predicting a
complex picture and that is why we pay 20% performance
fees. This is naïve and of course we must say the
whole purpose of our quarterly research is to find managers
with the wind at their backs, not in their faces. We are
trying to predict which type of manager will have the
wind at his back next year. Most equity hedge funds are
not very good at predicting these complex pictures. Computer
programs are completely lost in space. It follows that
the picture needs to be simplified for stock pickers to
So the second piece of the puzzle that follows the decline
in volatility is stabilization of the economic factors
that lead to the price of stocks. It can only happen after
vol has come down. Said another way, after markets stabilize
economies can stabilize. There is strong research to support
this view that markets are a better predictor of economies
and events than the reverse. There is even a new futures
market that uses market based or idea futures to predict
For equity bottom up strategies, the length of the run
for equity alpha is dependent upon this economic stability
piece. Politicians and fed governors must behave with
great insight to keep the peace in the economy. This is
why I have stated above that the decisions are getting
harder. Stable equities and growing markets are now dependent
on specific actions of our leaders, including our corporate
leaders. Still if my theories hold up, we will not be
dependent in the coming two years upon higher equity markets.
We can invest in market neutral. We can make good alpha
without much market risk and leverage it.
- The third necessary market change is geographic decoupling.
Prices of stocks should depend on the specific decisions
being made by leaders or consumers in a region or country.
We are beginning to see decoupling now as Asia decouples
from Europe for example. Technically it shows up as a decline
in correlation among global stock indices. See the correlation
below. Correlations were low on a rolling basis during the
time equity long short performed well. Correlations soared
at the same time returns collapsed. The correlation is now
declining and returns are picking up.
Stock pickers need to be focused on the intimate details
of a company; its products, its quality of management,
its competitive base etc. If these factors that they spend
their whole day on do not result in changes in the price
of that stock, poor alpha is the result. In today's market
there is specific decoupling. In Australia rates have
moved up, there has been a large change in the Aussie
dollar, and there is massive impact from trade with China.
Companies affected by this should not be moving lock step
with the NASDAQ. We are in the early stages of decoupling
and this is presenting enormous opportunities to pick
The fourth and final change that must occur is for individual
markets to exhibit more dispersion. Simply stated, if
stock pickers are going to make money picking stocks that
are miss priced from their expected future value, there
needs to be quite a few stocks that are miss priced to
choose from. Dispersion can be defined as a situation
where it is possible to buy all the stocks in an index
and sell the index against the stocks resulting in a profit.
It is a measure of miss pricing. Some will point out that
there has not been much dispersion since 1988 and I agree.
But still some dispersion is better than none and that
is what we have now. Dispersion will reappear but I argue
can only reappear after all of the above changes have
appeared in their proper order.
Before moving on to the implications for sub strategies,
let me mention several things wrong with the above simplistic
analysis. Some will point out that the rising volume of
exchange-traded futures is causing permanent damage to
dispersion and any form of decoupling. High volume in
index trading does create a situation where the people
doing that trading are not trading individual stocks and
therefore they are not creating dispersion. This is an
important consideration as studies show that 15% of the
traders in any market take money away from the other 85%.
We are supposed to be the 15% smart money taking excess
alpha. But if the dumb money is not trading with us any
more then we are trading smart money against smart money
in the same trades. Clearly some of this is occurring.
At Wolf we make the case that we can pick the 15% of the
smart money managers within the new massive smart money
pool. On the market side we believe this is creating some
drag on all managers' performance but not enough to say
the game is over.
Another problem is Reg FD. Hedge funds have lost some
of their information edge. Hedge fund managers typically
spent more time and money on a more concentrated portfolio
and thus produced a better result on that information.
This is still possible in emerging countries and may be
one reason higher levels of alpha are being generated.
In systems trading, there is no doubt that excess money
in the strategies combined with razor thin costs are taking
their toll. It is hard for smaller managers to compete.
Again this may cause some slight drop in rates of return
but it is not the core reason for low results.
Last I must acknowledge that low interest rates do cause
a drop in the rates of return for equity hedge strategies.
But when all of these extra factors are considered together,
they do not explain the lack of alpha. I believe our four
factors explain the bulk of the problem and that we are
about to see better times ahead. Let's now turn to exactly
how this plays out.
Starting with the decline in volatility mentioned
above, clearly during this time the best source of return
comes from the worst companies. The worst companies have the
most financial leverage. They benefit the most from reductions
in rates of distressed and high yield. The rule of thumb is
that when volatility begins to decline from very high levels,
buy the garbage. We did this last year only to experience
a double peak in volatility. This second peak gave us a chance
to add to holdings. Our combined "worst companies"
portfolio peaked at 29% in March and is now down to about
8%. The opportunity in this segment will end by April.
Moving to the second item, economic stability, we
can say that the best performers in that time frame are companies
with high earnings leverage. This can be defined as a company
where a small change in revenue causes a large change in earnings.
The period for this began in about May and should last well
into next year. I stated above that earnings leverage is at
an all time high. This implies opportunity. So let me take
the time to explain.
Economic stability implies stable growth not a stable depression.
Stable growth chews up excess capacity and so each incremental
sale results in bottom line revenue without attending new
fixed costs. The company does not need to invest in a new
plant. The company is already eating high fixed costs and
so as its sales recover, earnings appear quickly. Our current
low capacity utilization in the western economies implies
this very high earnings leverage. Of course it also implies
no need for investment.
When looking for high earnings leverage, one does not need
to look beyond the NASDAQ. We can debate whether it is expensive,
but we should not debate whether it has explosive potential
in both directions. I will borrow a mortgage word and say
these companies are "cuspy". One should not underestimate
how quickly these companies can turn around if the global
economy keeps ticking.
Our portfolio has a good quantity of these kinds of companies
though I will say that our net long is pretty small. We are
making money being long and short. It is more pure alpha than
bullish bias. The principal reason we do not have more net
long is that we think we can make more money in item one above
and item three below. We can only take so much risk.
During phase three above, geographic decoupling, it
is best to focus on specific regional markets. This period
started this summer and should last a full two years. Regional
is the right word but some may prefer the word emerging markets.
We are invested in both and do not think Hong Kong is an emerging
market. India is an emerging market and we are increasing
our holdings there.
Right now we are in the thick of an example of how economic
decoupling works. Asia in general has been cheap while the
west in general has been expensive. As perceived risk of the
world coming to an end wanes, capital rushes to the cheap
stocks. Right now this is Asia. People are buying Asia more
than specific companies. There is dumb money flowing in and
I predict that stock pickers in hedge funds will have a field
It has been well reported in our prior commentaries that
we are loaded down in Asia. Our best funds are all closed
and we are having trouble keeping up with the daily load of
new Asian fund launches. All this suggests that we are in
the early stages of another Asia asset reflation bubble. Given
the whole Asian topic is complex, I will not take it on here.
Instead I will promise that my next quarterly piece will contain
a lot about Asia. The piece will be on my favorite subject,
global trade. I will examine the impact of China, the impact
of high freight costs, the impact of commodity stockpiling,
and what a weak dollar does to global trade.
Let's move now to item four, equity dispersion. Each
month I am checking returns in dispersion based strategies
and making our option manager send me dispersion reports.
There is no sign of life and we have no exposure to dispersion
dependent managers. The dispersion period is the period of
greatest calm. The individual stocks that do best are those
with the most stability. Companies with stable franchises
may already be expensive by the time this period rolls around,
but the market's relative calm causes people to pay even more
for these reliable earnings streams. In some sense it is a
move to all that is market neutral. Stated simply, when there
is free money in dispersion, why do anything else.
During this phase one would expect for rates to be rising.
Our portfolio will be out of any company with high financial
leverage. It will be nearly out of the phase of earnings leverage
oriented companies. It will still hold a good amount of regional
plays that are benefiting from "economic leverage"
as these tend to have a lot of momentum and last well into
the dispersion phase. We are in the beginning stages of research
now in these dispersion strategies.
I began this analysis section with a quote from a great hedge
fund manager and will end with that same thought. It is hard
to enter equity strategies when most think of them as long
side trades in an expensive market fraught with risk. Equity
strategies are far more complex than that. Right now some
people in our industry seem to be stepping into these strategies
but I can say this is being done with little conviction. People
tell me it is more of a panic as their dull arbitrage portfolios
under perform equities. I believe this move will pay off.
Let's now turn to current events.
Current Hedge Fund Industry Events:
Given all the focus on equities above, one would think that
we never look at fixed income. We are watching the rise in
volatility in fixed income closely. June's violent moves occurred
when there was no chance of rates actually rising in the short
end. It is rare for the long bond to fall 20 points and every
time it does, it signals trouble ahead. In Japan, we nearly
had a failed government debt auction. Imagine the kind of
volatility we will get when it is time for rates to go up.
This risk is something we see coming about 9 months from now
and it is causing us to reduce or pull out of anything exposed
to short side fixed income volatility. We are already out
of anything that is just long high-grade fixed income. We
are now beginning to add strategies in some size that will
benefit from high fixed income volatility.
Lots of people are asking about mortgages. They were temporarily
cheap in the summer and we did not add money to the strategy.
Mortgage hedge funds are effectively short fixed income volatility.
This is true even if they do not employ a long mortgage/short
treasury strategy. Generally the portfolios are long complexity
and short simplicity. They are long either lower credits or
harder to price securities. No matter how you add it up, the
funds struggle to keep up if fixed income volatility is very
high. Their leveraged yield just cannot keep up with their
cost of hedging. Since we expect surprises in fixed income
volatility, it is the wrong part of the cycle to add money.
Said another way, mortgages are only cheap if volatility of
fixed income securities does not rise.
High Yield is near a price top/yield bottom. We have said
we would exit high yield at an 8% yield on the Merrill Index
and we are doing it through heavy dilution. Under 8%, our
managers will get short or we will not have them.
We should mention the importance of the price of oil. It
is too high and looking top heavy. We are watching it closely
because it is outside a normal range. In general we think
the long side of natural resources is a great place to be.
We are expecting (read hoping) for a retracement to increase
In April we talked about a temporary top in trend following
CTA's. Below is the chart showing the corrective action in
the rolling return. One new factor in the market is the trend
following equity CTA. Most big CTA's now have a meaningful
equity component. This was not a big factor in the last bull
phase. A combination of large longs in stocks and future large
shorts in long duration fixed income will reverse an historic
trend of negative correlation in CTA's. We saw the first signs
of this in the summer. CTA's are going to be very positively
correlated to stocks for a while. Any historical CTA data
should be regarded as yesterday's news. Related to this is
the rise of the commodity based CTA. After under performing
for three years, the commodity CTA's are making loads of money
while the financial CTA's struggle. Again, any historical
data is worthless. All the action will be in commodities.
Current Portfolio Changes:
During the summer we took a step back and reduced both portfolio
risk and leverage. We are now pushing leverage back up but
are not increasing portfolio risk. We are simply shifting
from debt to equities. We are shifting from long side bias
to a more long short bias. We are actively adding everything
with a discretionary trading focus.
Convertible Bond Arbitrage: We added some in September
but are generally avoiding this bonds up, stocks down strategy,
vol up strategy.
Distressed Securities: We are holding onto some residual
distressed. It is largely non US. Our portfolio has moved
down the capital structure to equity of distressed companies.
The book is much smaller as a result.
Emerging Markets: We have diluted the debt side of
the portfolio but still hold a long bias in debt. We think
spreads to worst in emerging markets have another 100 basis
points to move. We expect that to happen quickly. Our equity
portfolio is in Asia and we continue to add to it. We have
some exposure to Argentina. We missed Russia on the way up
and are missing it on the way down. I once spent considerable
time traveling through the former Soviet Union and was shocked
by the corruption. It is a very difficult market to be in.
Small Caps: My favorite manager of the moment is investing
in micro cap companies in Japan.
Event: We are diluting our very successful event portfolio.
It is important to point out that just because high yield
is tapped out, we do not need to exit our event managers.
Our event managers are running funds that are balanced long
and short. Our manager pool in particular knows how to be
short. If we examine the event chart on the next page, we
can see that event funds often show strong returns for long
periods of time. This 2003-4 cycle is likely to experience
a shorter period of sustained returns than the three years
from 95-98. That period has stronger fundamentals for corporations.
We can expect perhaps another year of strong results.
Fixed Income: Wait two years and then reinvest.
Macro: We are actively adding to short term oriented
trading macros. We prefer those that trade all markets and
with tight stops. We are avoiding long-term trend following
Market Timing/Systematic: We have no systematic long-term
trend following CTA's. We should get a reentry point in the
spring of 2004.
Merger: Our exposure is near zero. Our event managers
can more than cover the space.
Short Selling: Short selling is hitting an entry point.
We still have no exposure.
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